Yoran Yacht Company

1
Yoran Yacht Company

• Applying Real Options in Capital Budgeting
  Decision-making

2
Yoran Yacht Company

• The Yoran Yacht Company (YYC), a prominent
  sailboat builder in Newport, may design a new
  30-foot sailboat based on the winged keels
  first introduced on the 12-meter yachts that
  raced for the Americas Cup.
• Project is being considered in stages model
  testing, prototyping and production
• Stage 1 Model testing
• Initial cost 10,000 (t0)
• Probability of success 60
• Salvage value 0

3
Yoran Yacht Company

• Stage 2 Two Prototype Boats
• Costs 500,000 (t1)
• Probability of success 80
• Salvage value if unsuccessful 100,000 (t2)
• Stage 3 Production
• Costs 1,000,000 (t2)
• Expected cash flows
• If economy is strong, 3,000,000 for two years
  (t3 4)
• If economy is weak, 500,000 for two years (t3
  4)
• Equal probability of strong or weak economy (50
  chance)
• Cost of capital is 12

4
Traditional capital budgeting

• Calculate the expected value of the cash flows in
  years 3 and 4
• Calculate the NPV of the project, based on the
  assumption that you do all stages.
• Should the project be accepted?

5
Decision tree method

• Draw the tree
• Calculate the joint probabilities and NPV for
  each alternative branch of the decision tree.
• How can this method be used to assess option
  value?
• How can this method be used to assess risk?

6
Calculating joint probabilities

• Multiply the probabilities together as you move
  out a specific branch of the decision tree.
• Sum of the joint probabilities 1.0

7
Complete the decision tree
8
Calculating Expected NPV

• Multiply joint probability times NPV of specific
  branch
• Sum the weighted average NPVs for all branches
• Is there a benefit to staging the project?

9
Valuing a delay option

• Suppose Yoran Yacht decided to wait one year
  between prototyping and full production. Is there
  a value in this delay option?
• Should the modeling stage and prototype stage
  cash flows be considered?

10
Valuing the delay option

• By delaying production, Yoran Yacht can assess
  economic conditions.
• If the economy is strong, build the boats
• If the economy is weak, do not.
• What is the value of the delay option?
• Are there business risks associated with the
  delay?